Along-standing bastion of so-called safe returns on the mutual fund street is showing signs of cracks. The recent downgrades of debt papers issued by Infrastructure & Leasing and Financial Services Ltd and its group companies and subsequent defaults in some of them have impacted mutual funds. A total of about 33 funds (across liquid, ultra short-term bond funds, short-term bond funds, credit risk funds and others) had these companies in their portfolios; the cumulative value of these holdings in these funds added up to ₹ 2,308 crore as on August-end 2018, according to data from Crisil Ltd. The percentage of IL&FS exposure in debt funds to the overall debt funds AUM (assets under management) is 0.17% (end-August).

This is the fourth instance in the past three years of turbulence on account of a weak investment decision that is shaking up debt funds; JP Morgan India Asset Management (it’s investment in Amtek Auto Ltd), Taurus Asset Management Co. Ltd (in Ballarpur Industries) and Franklin Templeton Asset Management (India) Ltd (in Jindal Steel and Power Ltd) were the earlier cases.

The risk coming home is making risk-averse investors rethink debt funds. Suddenly bank fixed deposits (FDs) are looking attractive, especially on the back of rate hikes in the past one year. According to the Reserve Bank of India, term deposit rates for 1-3-year time periods have gone up 6.60-7% in the current financial year, up from 6.4-6.75% in 2017-18. The 3-5-year term deposit rates have gone up to 6.25-7.25% in the current financial year, up from 6.25-6.70% in 2017-18. In the meantime and due to rising interest rates, debt funds have suffered. In the past year, they have returned just about 4% on an average. Debt funds’ 3-year return stand at just 7%.

With credit risks with the IL&FS episode and low returns in the past year, should you just abandon them and stick to bank FDs? The short answer is no. To understand this better, we need a more nuanced understanding of debt funds.

Debt funds are not risk-free, but...

For years, debt funds were perceived as risk-free. And with good reason. During the 2008 credit crisis, investors the world over, including India, sold their equity as well as debt funds. Prices of debt securities (as well as equities) fell fast and furious, and mutual funds also had to sell their underlying investments to generate cash to meet sudden redemptions. Fund houses scrambled to raise money. In most cases at the time, their sponsor companies stepped in and bought debt scrips from—and gave money to—the fund houses.

Fund houses have, for long, passed off their investments to sponsor firms whenever their investments turn junk. But in the last three years, fund houses and sponsor firms have grown wiser. The losses are now rightfully passed on to the investors, and not just gains.

Sujoy Das, head-fixed income, Invesco Asset Management (India) Ltd, said the recent stress in the banking sector is also partly responsible. Das said that an infrastructure company typically needs money for long tenures to fund its infrastructure projects that takes time to build and execute. But since it’s unable to raise money for such tenures, it raises money for short tenures and then tries to repay them by either selling its assets, equity infusion or going back to the same lenders hoping the debt gets rolled over. “With many state-owned banks reeling under stress caused by bad loans, refinancing debt becomes difficult and such companies then have to raise money at much higher yields. Credit rating agencies have been found not capturing such stress," said Das. This despite the companies being backed by solid promoters, he said. When such defaults or eventual downgrades happen, debt funds suffer.

The question is: do distributors, financial advisors and investors understand the risks that come with debt funds? “No," said Ashish Shah, founder of Wealth First. “It is engraved in people’s mind that because debt funds have a diversified portfolio and fund managers and processes to identify scrips, investors won’t lose capital in debt funds," he said. Although Shah has been one of the earliest distributors to sell debt funds way back since 1996, he largely recommends tax-free bonds to his investors, aside from fixed maturity plans that stick to AAA-rated assets, liquid funds and uses government securities opportunistically.

It is engraved in people’s mind that because debt funds have a diversified portfolio and fund managers and processes to identify scrips, investors won’t lose capital in debt funds- Ashish Shah, Founder, Wealth First

Shah is a rare distributor who distrusts debt funds at large but the fact is that swift rating downgrades have cast a dark shadow on debt funds as well as rating agencies. Lakshmi Iyer, chief investment officer (debt) and head-products, Kotak Mahindra Asset Management Co. Ltd, insisted diversification reduces risk but agreed that risk cannot be eliminated. “It is a difficult situation and there has hardly been precedence in the past. Investors can solely draw comfort from the fact that MFs offer the benefit of diversification which therefore has reduced the pain point to some extent, though not eliminated it."

…post tax returns cannot be ignored

Debt funds come with a tax advantage if you remain invested for at least three years. Besides, the entire interest income from bank FDs gets taxed, whereas in the case of debt funds, only the capital gains get taxed.

Back-of-the-envelope calculations show that ₹ 1 lakh invested in a bank FD (assuming an interest rate of 7.50%) would yield ₹ 1.17 lakh after three years after tax (5.36% return) if you are in the 30% (without surcharge and cess) tax bracket. The same investment in debt fund would yield ₹ 1.22 lakh (6.82% return) assuming a 7.5% return from a debt fund.

“If investors are willing to stay invested for at least three years, it is very beneficial. Debt funds are also good for systematic transfer plans, whereby you transfer a fixed sum of money to equity funds every month," said Amol Joshi, founder, PlanRupee Investment Services.

How to choose the right debt fund and make money

The trick is to understand how much risk you are comfortable with before investing in any mutual fund, including a debt fund. Joydeep Sen, founder, wiseinvestor.in, said: “Accidents happen; that’s a reality. If equities go up or down, we tend to accept that. Similarly, one single default in a debt scrip doesn’t make debt funds bad." Sen also pointed out to failures in banks such as Kapol Bank, a co-operative bank which disallowed premature withdrawals from FDs when it ran into trouble. To be sure, such bank failures have been rare so far in India but not impossible as it’s made to believe, Sen adds.

If you don’t like volatility, stick to low-risk debt funds, like shorter tenured debt funds and corporate bond funds that invest in higher-rated assets. Some debt funds like duration strategy funds are opportunistic.

In a falling interest rate scenario, they outperform all other debt funds. But when rates rise, they underperform. But, a Crisil study points out that over long periods of time, the difference narrows down between less volatile funds like short-term funds and opportunistic funds like long-term bond funds (see graph).

Debt funds have consistently given higher returns than traditional fixed-income instruments. It’s just that investors weren’t sensitised with the risks that came along with them. However, if you wish to earn a higher return, then you need to take on some risk. Understand how much risk you are willing to take the next time you invest in a debt fund and you’re set.